Episode 12: Transfer pricing aspects of intangibles, with Filippo Miotto

The following transcript has been lightly edited for clarity. Filippo Miotto can be contacted at filippo.miotto@bdo.com.au.

Intro: Hello, and welcome to The LCN Legal Podcast. Bringing you expert views and analysis of the legal aspects of transfer pricing compliance. Our focus is always on real-world, practical insights that you can apply in your everyday work.

In this episode, Paul Sutton talks to Filippo Miotto, a Director in BDO Australia’s Transfer Pricing practice, about transfer pricing aspects of intangibles. The heart of the conversation is the latest draft of the ATO’s Practical Compliance Guidelines for such arrangements. Clearly, this is particularly relevant for groups that operate in Australia, but there’s also a wider perspective, because the guidelines provide a structured framework for assessing the risk level of arrangements, both while planning them and after the fact. We hope you enjoy the discussion.

Paul Sutton: Hi there Filippo, great to have you on this podcast.

Filippo Miotto: Hi Paul, great to be there.

PS: So maybe, Filippo, obviously you’re here to share some thoughts about intangibles and the Australian perspective on intangibles in particular. Maybe you could just introduce yourself briefly and explain how you got to where you are.

FM: Yes, thank you Paul. So I work for BDO in Australia, and I am a director in the transfer pricing practice. I have about 18 years of experience in international tax, the last eight specialising in transfer pricing. I moved to BDO six years ago, and before BDO I used to work for PwC in Luxembourg and in Italy for quite a number of years. And in transfer pricing my expertise is very much around the planning – in particular for small and medium-sized enterprises – which of course includes also migration and structuring of intangible arrangements.

PS: Got it. Great. Thanks Filippo. So we’re here to talk about intangibles. Maybe you could set the scene and just explain why is it that intangibles tend to attract so much attention from tax administration? So what is it about this as a risk area, if you like, for transfer pricing?

FM: Yeah. Let’s start with the definition of intangible assets, or what is an intangible asset? So the definition is quite broad. And the ATO, or Australian Taxation Office, refers to the OECD Guidelines when it comes to the definition of an intangible asset. And if I read the OECD Guidelines, intangible assets refer to property, assets and rights that are not physical or financial assets, which are capable of being controlled for and used in commercial activities, and are not restricted by any accounting or legal concept or any definitions. And as you can see, Paul, this definition is quite broad. And we talk about intangibles because definitely intangibles are becoming a significant source of competitive advantage for business, and they are obviously quite central to the creation of the value for the customers, and also for the shareholders and any stakeholders in general. And I may also add that nowadays, intangibles can be even more valuable to a business than tangible assets. But of course, there could be differences depending on the business and the industry.

Just to give a few examples. So when we talk about intangible assets, we may talk about patents, we may talk about brands, trademarks, we may talk about rights under contracts, trade names, know-how and trade secrets in general. And I recently came across a quite interesting situation of a transfer of a client list in the context of a new distribution arrangement. So again, an intangible, which could be potentially very valuable for the parties, which was transferred across. Well, the focus of the ATO when it comes to intangibles is from many different perspectives. But in the context of the PCG [Practical Compliance Guidelines], which is what we are talking about today, the main risk is that the Australian entities are undercompensating in the context of a transfer of an intangible assets for performing certain key functions around this asset.

PS: Got it, yeah. And I guess if you go back to the origins of BEPS, the whole BEPS project, and the perception – probably the reality to some extent – of artificial shifting of profits, then intangibles may be regarded as easier to move than physical plant, actual people. And so the sort of classic horror stories, if you like, of artificial moving of IP into BVI or offshore jurisdictions, or something like that being an obvious area of focus.

FM: Paul, if I may add, there’s a specific category of intangible assets, which is worth mentioning, which is the hard-to-value intangibles. Let me put it this way. So, intangibles are already quite difficult to value because of their intangible nature. But within the category of intangible assets, there is this sub-category, which is the hard-to-value intangible assets, which the OECD has given a separate recognition and makes any exercise of valuation even more difficult.

PS: Yeah, totally. Okay, so let’s talk about the PCG, or the specific PCG that we’re here to focus on. So, Practical Compliance Guidelines. It is 2023-D2, but perhaps before we dive into that… so this is part of a series of Practical Compliance Guidelines issued by the ATO. So maybe you could give us an overview of what the portfolio looks like, and then talk about this specific one.

FM: Yeah. So the Practical Compliance Guidelines are guidelines issued by the ATO in relation to the practical implication of the tax laws, and outline their administrative approach: a typical approach that the ATO has in relation to certain transactions, which are quite risky from their perspective. And the purpose of the ATO is provide certain guidelines to the taxpayer so they can effectively self-assess their tax risk using a particular risk assessment framework. So in Australia, we have PCGs for distribution arrangements, now for intangibles arrangements, but also for financial transactions, for transfer pricing documentation. And I would say that they are quite useful because you can understand what is the perspective of the ATO in relation to risk arising from certain transactions, and you can also better understand what is the risk that, as a taxpayer, you may face.

PS: Fine. Okay, so here we’re talking about the second draft of the PCG relating to intangibles. So what’s the structure of it, how does it work and how does it break down?

FM: Yeah, so this is the second version. There were a few changes compared to the previous version, but the core part of the PCG hasn’t changed. So in the context of these intangibles arrangements, the PCG sets out the ATO compliance approach, in particular to the following situation. So the first one is the mischaracterisation of the DEMPE functions – activities undertaken in connection with an intangible asset. And DEMPE activities are quite important in the context of transfer pricing. DEMPE stands for development, enhancement, maintenance, protection and exploitation. And so these are the activities which are normally considered key when it comes to an intangible arrangement.

Of course, also, the focus of the ATO is around any potential structuring or restructuring in relation to the ownership of the intangible asset, and all the subsequent activities undertaken by the parties in connection to this intangible asset which might have migrated outside of Australia. As I said, it’s a very common approach applied by the ATO issuing these Practical Compliance Guidelines. And as we will see more in the course of our conversation, you will understand why this is becoming quite a key tool for taxpayer and tax administration.

PS: So let’s talk about the structure and how the reporting system works under the PCG. So it’s a sort of self-assessment that the taxpayer has to undertake themselves?

FM: Yes, Paul, so what I would like to point out here is that in the PCG, there is a perspective from the taxpayer and there is a perspective from the ATO. So if we start with the ATO perspective, the ATO can use the PCG to assess the compliance risk associated with the intangible arrangement, but they can also tailor their engagement around this risk. So, for example, if the result of the application of the PCG to the intangible arrangement is a high risk, then the ATO may want to allocate more resources to the review of the transaction. If the result of the PCG is a low risk, then the ATO may not allocate any resources at all considering the transaction low risk. And that’s the ATO perspective.

But then we also have the taxpayer perspective. So, in essence, a taxpayer can use the framework of the PCG to understand what is the compliance risk that might be presented by an intangible arrangement. The specific feature of the intangible arrangement that the ATO may consider to present a greater compliance risk, but also the evidence that the ATO are likely to ask the taxpayer to produce in relation to the intangible arrangement, if there is an ATO review or an audit. And this also includes the level of engagement that the taxpayer should expect from the ATO, on the basis of the risk deriving from the intangible arrangement.

PS: So it is a planning tool for taxpayers in terms of looking ahead and deciding what approach to adopt and being prepared for the level of evidence that will be expected.

FM: Yeah, absolutely. And this PCG in particular is divided in three parts. So part one provides the ATO compliance approach for an intangible arrangement. Part two, which is the core of the PCG, explains how the ATO assess the compliance risk of an intangible arrangement. And the last part, part three, provides an outline of the types and level of evidence that the ATO would expect when examining an intangible arrangement.

PS: OK, great. How does the reporting actually work? What’s the timing of that? Is it actually mandatory for taxpayers to self-report?

FM: Yeah, that’s a good question, and it depends: the answer is ‘yes and no’. In general, the PCG is not mandatory. So you are not obliged as a taxpayer to self-assess your tax risk based on the PCG. However, for a certain category of taxpayers – large taxpayers, with revenues of more than 250 million in Australia – the preparation of the PCG becomes mandatory because there is a disclosure obligation in a particular schedule of the income tax return, which is called the reportable tax position. So in this case, it would be mandatory. But also another situation that may arise when, indirectly, the preparation of the PCG becomes strongly recommended: a tax audit. So in a tax audit, the ATO may ask the taxpayer whether it has self-assessed its risk based on the PCG. So, yeah, typically, in the first information request sent by the ATO, if you have transactions which are potentially subject to a PCG, there is a sort of expectation by the ATO that the taxpayer has self-assessed its position.

To summarise, it’s not mandatory, but I think it’s quite important to understand what is the risk. It’s a useful tool. And also, if you put the use of this tool in the context of the governance framework or the governance expectation that now tax administrations in general are setting, it becomes quite important.

PS: I mean, it sounds like it’s squarely within this ongoing dialogue between the ATO and the advisory and taxpayer community as regards expectations and evidence and so on. So can you talk a bit more about the examples that are given in, is it part three of the PCG? So the kind of examples that are set out as intangibles arrangements which may need to be assessed?

FM: Yeah, so there are 13 examples, and these 13 examples are in connection with the different levels of risk. So we have examples for the high risk zone, for the medium risk zone, and also for the low risk zone. And the examples cover typical situations, such as centralisation of intangible assets, bifurcation of intangible assets, migration of pre-commercialised intangible assets (this goes back to my initial comment about how to value intangibles), contract R&D arrangements, cost contribution arrangements…. So the examples are quite useful, because they are quite detailed and, effectively, they provide a fact pattern and they simulate the application of the PCG on the basis of the fact pattern. So it’s very useful guidance provided by the ATO with examples.

PS: So we’re talking about two risk categories. One is about remuneration of DEMPE functions – or under-remuneration of DEMPE functions – performed in Australia. And the other one is about migration of IP, or deemed migration of IP.

FM: Yeah. So, broadly, the PCG covers two situations involving intangible arrangements. So the first one is the migration of an intangible asset, and the second one is any other arrangements that may arise in connection with intangible assets. So if we dig a little bit further into these two categories of situations. So with the first one – the migration of the intangible assets to an international related party – the PCG, and the risk assessment framework under the PCG, provides a point scoring table having regard to the following factors.

Restructuring or change of ownership in relation to the intangible asset (for example, if the Australian entity is disposing the assets to an international related party).

The second factor is the substance of the entities, in particular the substance of the international related party and its ability to perform the so-called DEMPE functions.

And a third factor, which is quite interesting, is the tax outcomes of the intangible arrangement. So the ATO also wants to understand what is the overall tax outcome which derives from migrating these intangible assets and performing certain functions in connection with it.

And I guess what is also worth mentioning is that there are some particular instances which immediately place the taxpayer into the high risk zone. For example, if there is a transfer to a newly established entity, then you may already be placed in the high risk zone. Or for example, if there is a particular tax outcome very favourable to the taxpayer, even without any considerations around the underlying economic substance, then the PCG would place you in the high risk zone. And I guess probably one comment which is important to make is that the PCG per se is not an indication of whether the transaction has been undertaken in accordance with the arm’s length principle. So the PCG is purely a risk assessment tool which may inform about a particular risk deriving from a transaction, but a taxpayer could be placed in a high risk zone, but still the transfer pricing position could be absolutely in accordance with the arm’s length principle. The only difference is that of course the ATO would try to understand more about the transaction.

PS: So you could say that the high risk category really means higher scrutiny category. And I guess that leads on to the evidence expectations, in terms of what does it mean to be in that zone where you really need to be able to justify the position very carefully? So maybe you can give us an outline of the evidence expectations.

FM: Yeah, well, it’s a fair statement. It’s also fair to say that it’s not so easy to fall under the low risk zone. You really need to have a very plain vanilla arrangement to be able to fall under the green zone or the low risk zone.

But in terms of evidence. So that’s another interesting question, because evidence is quite an important concept in transfer pricing, and becoming more and more important. The PCG is providing examples of evidence that the ATO is expecting to examine in a review or in an audit. And I guess number one is around the commercial reasons and the decision-making process related to the intangible asset. And there are very specific examples – I could list, for example, market evaluations, briefing materials, presentations, emails, board minutes. So you can really have a feeling of the level of evidence that the ATO is expecting a taxpayer to be able to produce. And in addition to commercial reasons and decision-making process, there is evidence around legal agreements, governance framework, transfer pricing documentation, with of course a strong focus on DEMPE analysis. But also I can mention tax advice, and understanding what is the tax advice given by your advisor, in the context that we are experiencing now, where the tax authorities are trying to disengage aggressive tax planning given by tax advisors.

But also I can mention evidence of tax profit outcome. It’s quite interesting, again, to understand whether the taxpayer has done any analysis of the tax outcome deriving from a particular arrangement around the intangible asset. So definitely the ATO is putting the bar with the expectation of the evidence quite high.

PS: I think it’s such a great reminder. So obviously it has specific application in Australia and the ATO’s expectations, but I do think it’s a great reminder for the TP community globally to say, well, this is how transactions can look from an outside view. It’s all very well going through the tax technical analysis or transfer pricing technical analysis, but when you zoom out and say, why was this structure implemented in the first place? What was the rationale for it, what was the economic effect of it? And therefore, what evidence is needed in order to demonstrate that it is a legitimate structure? It’s a really good reminder.

FM: Yeah, absolutely. I think the ATO is leading the way in the transfer pricing community. Absolutely. It’s very advanced. And I come from Europe, obviously, with my experience in Italy and in Luxembourg, and I can see that the level of analysis details and now evidence required by the ATO, it’s quite advanced.

PS: I mean, just giving one example that I came across when reading the PCG is about declining royalty arrangements. And obviously this is where you’ve got existing IP, maybe treated as legacy IP, and so that IP owner is agreeing to allow the rest of the group to use it, but with a declining or reducing royalty over a period of time. And yes, that may make sense from a pure economic or benchmarking perspective in terms of the amount of the declining royalty, but the substance of the arrangement is that the IP owner is basically giving up on the long-term value of that IP. So it’s important to remember that.

FM: Yeah, absolutely. And there are some arrangements which were very popular a few years ago in relation to intangibles, which are probably going to be more difficult to implement now. As you said, the concept of the declining royalties or the so-called ‘die on the vine’ of the IP, it’s also something else that probably we will see less and less unless there is proper substance and evidence able to support it.

PS: Yep, totally. Well, I’d like to move on and talk about one of the other measures in the pipeline in Australia. So this is the multinational tax integrity regime. Maybe you can give us a brief outline of what this is about and what is coming down the line in that regard.

FM: Yeah, this is still a draft law, but effectively Australia is introducing in the tax system a provision to deny tax deductions for payments relating to intangible assets connected with low corporate tax jurisdictions. First of all, it’s another measure around intangible assets, and I think it’s another indication of really the focus that the ATO and the Australian policymakers in general are trying to give to intangible transactions. Definitely, in Australia, intangibles financial transactions are in the top five of the key dealings which are currently under great scrutiny from the ATO.

PS: OK, great, well, we’re coming to the end of this show, so perhaps you could leave us with some key takeaways, or the kind of things that you’re talking about with clients when they’re thinking about structuring or restructuring their intangible arrangements. So what are the key takeaways or key discussion points?

FM: Definitely the first message would be in relation to the identification of the intangible asset. So as we said at the beginning, the definition of intangible asset is quite broad. So it’s very important to review all the commercial and financial dealings between international related parties to make sure that all intangible assets are properly identified. And just to go back to the example I made at the beginning, when a company decides to start to distribute its products overseas and may set up a distribution arrangement with a related party, there could be so many different intangibles used within this distribution arrangement that are important to review and to consider from a transfer pricing perspective, and make sure that all the parties are properly compensated for their use.

The other message is around the importance of contemporaneous evidence when it comes to intangible assets. So, as we said, evidence is absolutely instrumental to understand the roles and the main features of the arrangement. But having this evidence contemporaneous gives you the advantage of making sure that you collect all the available information and documentation at the time of the transaction, because as we know, a tax audit or review may come a number of years after the transaction is entered into by the parties. So collecting evidence could be quite difficult down the track. So it’s better to have all the evidence collected in a contemporaneous fashion.

And I guess the last message is the importance of ‘why’. So when a taxpayer enters into a transaction, it’s absolutely key to understand why the taxpayer is entering to the transaction. What is the commercial rationale? What is the economic benefit that the taxpayer receives from this transaction? This is especially true in the context of intangible assets.

PS: Totally. Well, thank you very much Filippo. It’s been fascinating. I would heartily recommend everyone who’s listening to actually read the PCG, 2023-D2. It’s really interesting reading. Obviously there are specifics in terms of supporting Australian taxpayers in relation to their activities, and thank you very much for giving that kind of practical perspective on everything.

FM: Thank you Paul for having me here. It was a pleasure.

Outro: Thanks for listening to The LCN Legal podcast. We’d love to hear what you think. You’ll find the contact details on our website, lcnegal.com. In the blog section you’ll find a transcript of this episode which includes Filippo’s contact details. And on the blog and in the Training Hub section you’ll also find much more about intangibles, Australia, the ATO, and other related issues. If you enjoyed this episode, please subscribe. Go to your podcast provider and search for The LCN Legal podcast. Until next time: goodbye.